Financial Friction

Time. You cannot hold it. You cannot see it. You cannot stop it. But… you do have a choice. Utilize it or don’t.When it comes to planning and building wealth (or for anything) – time matters. And, compounding most certainly does too.

1

Time Value of Money

2

Compound Interest

These two concepts are both fundamental, foundational and most certainly essential. The sooner you learn them and the sooner you apply them – the better off financially YOU WILL BE!

Whether you realize it or not, time and compound interest are powerful. Time allows for potential. Compounding allows for growth. Both concepts are simple, so let’s analyze why time and compound interest matter.

What is Time Value of Money?

Time Value of Money. You may have never drawn the comparison that time and money have a mutualistic relationship - it does. Money not only has a monetary value; it has a time value too. Let’s look at a quick example:You completed a service for a client, and you are owed $10,000 dollars. The client calls you to let you know that he is ready to give you a check for the bill. He gives you a choice to swing by his house to collect the $10,000 before he goes out of town for a month. You have a choice. Do you wait for a month or do you go by his house to collect what he owes you?

Some may say it doesn’t matter as long as they get paid, but time value of money says it does matter. Why? Because receiving money today is worth more than receiving that same $10,000 dollars at any given point in the future. Yes, even if you had the option to receive it tomorrow. Your money has potential earning capacity. This means that the $10,000 you received today; you have the potential to earn money on that $10,000 today. So, if you took the $10,000 a month from now instead of today, you would miss out on all the potential earning capacity of each day you did not have the funds.

Simply put:• If you receive the money today – you can make money on your money today.• If you receive the money tomorrow or at any given point in the future but had the option to receive the money today – you lose out on the potential earnings of today and every day in the future that you delay receiving the money.

What is Compound Interest?

Formula: FV = PV (1 + r)^n(FV): Future Value(PV): Present Value(r): Interest rate earned per year (%)(^): Exponent – the number of times a number is multiplied by itself(n): Number of periods

Said to have been described as “the eighth wonder of the world” by Albert Einstein, compound interest can be simplified from the formula above. Yes – FV, PV, R, and N are each important in making your money grow, but where you capture the most growth is often the most overlooked piece of the formula. The “upside-down v” or exponent allows for compounding. It allows you to exponentially grow the present value (PV) to a greater future value (FV). To get from PV to FV the compound interest accrues - this means that not only will you earn interest on the principle (initial amount), but also you will earn interest on your interest.

Yes, you read that right. You can earn money on the money you’ve earned.

Let’s take the previous example above and say you decided to swing by your client’s home to receive the payment of the $10,000. Let’s also say you immediately took those funds to the bank and put it in a savings account. It also turns out that the savings account at your local bank is yielding 10% (for simple math – FYI, most savings accounts yield less than 1% unless it’s an online bank). Here’s what that would look like if you deposited the $10,000 and did not touch the funds for the following years:

After year one, you would have made $1,000, because you earned 10% on your principal ($10,000). In year two you would have earned $1,100, because you earned 10% on your principal ($10,000) and the interest you earned from year one ($1,000). This is what compounding looks like.

How does time value of money and compound interest work together?

In the compounding example above, let’s assume you put the $10,000 under your mattress for ten years, then decided to put it in that same savings account that was offering a 10% yield. Instead of turning your $10,000 into $67,275, your $10,000 would only be worth $25,937.40. This is due to the fact that you decided not to make the choice to utilize time, you would have lost out on $41,337.60. That’s why time matters and coupling it with compound interest amplifies its importance.

Key takeaways:

• Money grows, but you must have it to receive the potential of growth. If given the option, ALWAYS take the money NOW. • Compound interest is perhaps the 8th wonder of the world. You can earn money on the money you’ve earned.

Yes, my pay stub was all sorts of messed up and if I didn’t understand it, then the issue would have persisted.

True story. For months I had collected a paycheck only caring about the bottom-line number (Net Pay). Of course, I didn’t have any real reason to look at the pay stub because it would have only told me what I already knew – that I got paid! Also, I assumed payroll processors could never mess up an employee’s pay…

It was Friday afternoon (I had been working for the company for a little over a year), I received my pay stub and as I began to fold the pay stub to put it in my desk drawer as I did many times before - curiosity struck,

As I was prompted by these thoughts, I noticed something was off. The deductions – this was the part that was all jacked up…

Most likely, you don’t review your pay stub for two reasons:

You know you got paid.

You got paid, cool! But what if you could have taken home more or saved an issue from getting even larger? Your payroll processor is human just like you, which makes them susceptible to the same mistakes you make. Even the most well-intentioned person messes up.

Education. You do not know all the terms or how it flows.

Our educational system does not teach people to read a pay stub in school, so how do people learn? If you don’t understand what you are looking at, ask someone to walk you through it or keep reading. Remember, there is no shame in making sure you’re being compensated for the work you’ve performed. I guarantee you that you are not alone in not understanding a pay stub.

Below, I have covered the minimum of what every pay stub should include. Keep in mind that pay stubs vary in look and the type of deductions based on your situation.

The Basics:

What is a Pay stub?

The document that outlines detail about your compensation.

The first piece of information to take into consideration when forming a budget. Every number in a budget flows from the information contained on a pay stub.

Employee Name

This is YOU! (Just wanted to make sure you’re still reading)

Current and YTD

Current is what you were paid for in the most recent pay period.

YTD (Year-To-Date) is the sum of how much you have earned in the current calendar year, thus far.

*You should see Current and YTD in each category on your pay stub.

Earnings

*This section may look different depending on the way an employee earns wages. If you are paid hourly, you will see the hours worked and the rate (how much earned per hour). If you are a salaried employee, you may only see a current and YTD number. You may also see other forms of compensation within this section.

Gross Pay

The amount before any taxes or deductions have been subtracted.

Net Pay

The amount after subtracting taxes and deductions from gross pay. Net pay is commonly referred to as “take home” pay.

Deductions

Taxes

Federal Income Tax

Depends on the number of exemptions you claimed when filling out the W-4 Form when you were first hired (it informs your employer on how much federal tax should be withheld).

FICA (Federal Insurance Contributions Act)

Social Security Tax

For 2019, the tax rate is 6.2% (the employee and employer both pay this tax for a total for 12.4%). Any dollar earned over $132,900 is NOT subject to this tax.

Medicare Tax

For 2019, the tax rate is 1.45% (the employee and employer both pay this tax for a total for 2.9%). Every dollar earned is subject to this tax - Any wages earned over $200,000 have an additional 0.9% tax for the employee.

State Tax

Each state has different laws regarding state tax. For more information, consult your Human Resource Department.

For an example, see the sample paystub above under the taxes section – there is a withholding for the state of North Carolina.

*Employers have additional taxes they must pay because they have employees. These additional taxes do not impact your earnings in any way.

Pre-Tax (Before)

Deductions taken from your gross pay before taxes are withheld. Pre-tax deductions reduce your taxable income, which will more than likely result in paying less Federal Income and FICA tax.

Below are examples of Pre-Tax Deductions:

Certain Retirement Plans

Life Insurance

Health Insurance

Health Savings Accounts or Flexible Spending Accounts

*Though you save on taxes when this deduction occurs, you may owe taxes on the withheld money in the future.

Post-Tax (After)

Deductions taken from your gross pay after taxes are withheld. Post-tax deductions do not reduce your taxable income, but could be beneficial depending on how these deductions are used.

Below are examples of Post-Tax Deductions:

Certain Retirement Plans

Disability Insurance

Life Insurance

Garnishments

Charitable Contributions

…To conclude my story, the payroll department had mistakenly deducted the 401k match (Employer contribution to my 401k) from my earnings for more than a quarter of the year. Thus, resulting in my net pay being less than it should have been. So, if you don’t want your paycheck to be jacked up, get educated on how to read your pay stub and scan over it each pay period.